Having your cake and eating it

28 January 2019 - Elizabeth Nichols

Luke Morris, Corporate Finance Partner gives his opinion on Patisserie Valerie and wonders how this situation could have been allowed to happen?
At the risk of sounding like an old man, when I was a lad the audit profession majored on something called "professional judgement". Much of this was based on the years of cumulative knowledge and experience of the auditor. A fantastic former manager of mine talked about learning to "audit by your nose".
This commercial instinct has become a tool for any adviser undertaking Corporate Finance work. Quickly figuring out where the issues are and identifying the show-stoppers. How to structure a deal to mitigate risk and address the other side’s concerns, and, crucially, knowing what something is “worth” are all part of the training for a Corporate Finance professional.
Then, in 2001, Enron happened, and with it the Big 5 became the Big 4. Pretty sobering stuff when 100,000+ people lose their jobs overnight…
At the time many people started to question whether professional judgement had had its day. Predictably the regulatory and training pendulum swung the other way. Compliance, not commerciality, gained the upper hand in firms across the world. Firms talked endlessly about being "committed to audit quality". Auditing became more rigid, checklist-driven. Less “audit by nose”, more auditing by rote.
But, it could be argued, perhaps things have now gone too far the other way?
One of the stockmarket sectors that has totally tanked in recent years has been "casual dining". Ask anyone. Closely aligned to retail (and its related footfall or lack of), it has fallen victim to fierce competition from the Deliveroos of this world opening the market to new smaller entrants, the changing dining habits of vegan millennials nursing an Americano all afternoon in order to use the free wifi… It has been brutal.
My family rarely goes to Pizza Express without some voucher code or other, which seemingly reduces the price of the meal to what must be close to cost price. Nice for us, but what about the shareholders?
All that notwithstanding, the Patisserie Valerie numbers in recent years seemingly bucked the trend. “PatVal” reported sustained rises in sales. Its share price doubled in four years. Stores opened regularly, and margins appeared to be better than Starbucks’.
It is arguable that a professional evaluation should have raised questions such as why an overdraft was needed when there was apparently lots of cash? Where was the interest income on the cash? How come revenue per store was so stable, despite the huge growth curve of store numbers (almost as if someone had made the numbers up *innocent face*)? But, most of all, how was it that “PatVal” bucked the trend of a sector that has been battered around and has had such brutal competition? Were their cakes really that good?
As the whole mess unravels, it is impossible not to question how a retail operation of their size and strength could get to this point.  This is an AIM listed business, backed with investments from our pension funds and ISAs. It has non-executive directors, audit committees and national firm auditors. It's not a ‘Ma and Pa’ greasy spoon at the end of the road.
An auditing nose should have instinctively smelt a (sugar coated) rat. How many times have we heard the old saying that if something sounds too good to be true then it probably is? I know that hindsight is a luxury, but this has happened a few times now. Professional judgement needs to make a comeback.

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